Site Mobile Navigation

MUTUAL FUNDS; Vanguard's Index Killer

ASK John J. Nagorniak, manager of the Vanguard Growth and Income fund, how he manages to beat his rival funds year after year and he deadpans: ''We consistently bore the opposition to death.'' Such is the life of a quantitative fund manager.

Mr. Nagorniak, chairman of Franklin Portfolio Associates in Boston, which manages the fund, likens his job to baseline tennis, the relentless, back-and-forth volley of balls favored by Andre Agassi instead of, say, the charge-the-net play of Pete Sampras. ''We're never going to be the top fund in any year. But over all, you end up ahead of everybody else,'' Mr. Nagorniak said.

In quantitative investing, managers rely on computer models to pick stocks, instead of focusing on independent analysis and meetings with company executives.

For investors who prefer consistency to roller coaster-like excitement, the results have been gratifying. For the 10 years ended March 20 , Vanguard Growth and Income had a 19.1 percent annualized return, compared with 18.9 percent for the Standard & Poor's 500-stock index and 16.2 percent for the average large-capitalization value fund tracked by Morningstar Inc., the financial publisher in Chicago.

For the short term, the fund, which changed its name from Vanguard Quantitative Portfolios last April, has really taken off. For the 12 months ended March 20, the fund had an annualized return of 46.4 percent, compared with 42.8 percent for the S.& P. 500 and just 35.1 percent for the average large-cap value fund.

Unlike index fund managers, who build portfolios that seek to replicate, say, the S.& P. 500, the $2.6 billion Vanguard Growth and Income Fund uses the S.& P. 500 as a framework to select stocks using computer-driven quantitative measures. And unlike most active managers with more lofty ambitions, Mr. Nagorniak succeeds.

The bottom line for investors is that the fund will not overshoot the index by an enormous margin, but it will not lag behind it by much either. Over the last decade, the fund has never outperformed the S.& P. 500 by more than 3.8 percentage points during any calendar year and has never trailed it by more than 1.9 percentage points, according to Morningstar.

Mr. Nagorniak, 53, has long worked in the rarefied world of quantitative investing, starting as a quantitative analyst at John Hancock Life Insurance in June 1970. ''He's been doing it for probably longer than anybody in the business,'' said Don Powell, currently chairman of Van Kampen American Capital and co-founder with Mr. Nagorniak of Franklin Portfolio Associates.

Many quantitative managers develop a model and stick with it even when it stops bringing them superior returns. Not Mr. Nagorniak, who is constantly fine-tuning his models. ''The key to his success has been the adaptive nature of this process,'' Mr. Powell said.

So how does Mr. Nagorniak do his stock picking? He begins by ranking a domestic universe of 3,500 stocks using 40 measures developed at Franklin Portfolio. He then assesses the results against the stocks in the S.& P. 500. His goal is to make sure the portfolio is balanced in terms of its exposure to various industries and to factors like capitalization and leverage, as well as price-to-book and price-to-sales ratios.

An error has occurred. Please try again later.

You are already subscribed to this email.

The 40 measures that Mr. Nagorniak employs run from simple to excruciatingly esoteric. But they fall into four general categories. The first looks at what are called price-sensitive relative-value measures. These include price-to-earnings ratios, return-on-equity, yield and the price-to-sales ratios mentioned above.

The second category uses information continually culled from analysts' data bases. It covers earnings momentum measures, like earnings growth estimates and earnings surprises, to find out the near-term prospects for each company.

The third set of measures looks farther into the future -- about 7 to 10 years -- to assess whether a stock is expensive or cheap today. This is done by discounting the future expected cash flows of the company and the dividend paying ability of those cash flows. The last is a catch-all category of unrelated measures, tracking everything from insider buying to whether a stock price is on an upswing or a decline relative to the rest of the stock fund universe.

Despite the fine tuning, the screens can sometimes lead to ambiguous results. Some stocks look great by some measures and awful by others. Each of the measures is weighted according to how well it has done in forecasting stock returns and how it interacts with all the other measures. The measures in the supplementary category, for instance, account for only 10 percent of the overall score for any stock. So Mr. Nagorniak scores each stock according to the weighted composite of the individual scores for each measure.

The 3,500 stocks can then be ranked from the best to the worst, and usually about 115 or so are selected. The list is then assessed against the S.& P. 500 itself and evaluated for its overall risk.

Mr. Nagorniak steps outside his number driven world when necessary. If a company is likely to be punished by some extraneous factor, like a lawsuit, he won't buy it.

How does all this play out with a particular holding? Merck & Company was the second-biggest holding in Vanguard Growth and Income at the end of February, behind Ford Motor. Relative to its past price history, the stock ranks ''well below the middle of our list,'' Mr. Nagorniak said.

But Merck looks a little better when Mr. Nagorniak considers forward-looking measures, like forecasts for future earnings versus the current stock price. The stock is a less attractive buy today at a price of $127.75 than it was when Mr. Nagorniak bought it last October, when it was trading around $90. The reason it ranks so high in the portfolio is that it represents almost 2 percent of the value of the S.& P. 500. If it were a negligible part of the benchmark, Mr. Nagorniak said he certainly would not own as much as he does.

Running stocks through models and constantly reassessing them leads to relatively high turnover: 75 percent versus 5 percent for the Vanguard Index Trust: 500. Thus, Vanguard Growth and Income is much less tax efficient than a straight index fund, said Daniel P. Wiener, editor of the Independent Adviser for Vanguard Investors, a newsletter based in Potomac, Md. This makes the fund a better choice for retirement focused investors. In fact, nearly 50 percent of the assets in the fund are in tax-advantaged accounts like 401(k)'s and individual retirement accounts.